Simple models and the macroeconomics of price controls

I hear that Argentina has imposed [update: economy-wide] price controls. I know next to nothing about Argentina, but I have spent some time thinking about the macroeconomics of price controls.

I can easily build a simple macroeconomic model showing that price controls are a good thing that can make everybody better off.

I cannot build a simple macroeconomic model showing that price controls are a bad thing. I don't think anyone else can either. Unless they assume the government price controllers are stupid. But that doesn't mean price controls are not a bad thing.

My guess is that price controls may be a good thing in the short run but will be a bad thing in the long run. I can explain why I think that, but I can't build a model to show that. That's the trouble with models.

If the real world really were as simple as my simple model, then price controls really would be a good thing, in both the short and long run. But the real world is much more complicated than my ability to model it, so I think that price controls will be a bad thing, at least eventually. But I can't model it, because it's too complicated for me to model.

I think that it is thoughts like this that drive Austrian economists to distraction. I sympathise. I think they are right. The, um, medium of modelling biases the message.

Here is a sketch of my simple model showing that price controls can be a good thing. It's exactly the same model that I illustrated in pictures in this old post. It's an absolutely bog-standard New Keynesian model with monopolistically competitive producers. The representative firm produces where Marginal Revenue equals Marginal Cost to maximise profits. But since the representative firm faces a downward-sloping imperfectly-elastic demand curve, its Price exceeds MR, and so P > MC.

Take that model, start in full equilibrium, freeze prices by law, then increase Aggregate Demand, and increase output, until the representative firm is producing where P = MC. The representative agent's welfare increases because an imperfectly competitive economy now behaves as if it were perfectly competitive. (The new equilibrium is at Y^ on LRAS(2) in my old post.)

I think that simple model which shows the benefits of price controls contains an important truth. But it is a very long way from the whole truth. What it leaves out is more important than what it contains.

What it leaves out is everything that, say, Hayek talked about in The Use of Knowledge in Society. We don't live in a simple world with identical people and identical (except for the flavour of ice cream each produces) firms where any one person (like the government price controller) can know everything about the economy. And things keep changing over time. So the government price controller won't know what prices to set, and the central bank won't know how much to increase AD, and everybody will think up all sorts of ingenious but socially costly ways to get around the price controls anyway.

Here's my best guess of what will happen. In the short run Argentina may see some benefits, for the same reason my simple model shows the benefits of price controls. Because in the short run the things that affect optimal relative prices and resource allocation usually don't change much. But in the long run those things change a lot, as small changes cumulate over time, as people discover new ways of doing things. That's where you need Hayek at work. But you can't get Hayek at work if the central planner freezes prices, unless you can convince him to unfreeze your price, which means you have to convey to him your local knowledge of time and place. (This is why centrally planned economies tend to have that frozen-in-time science fictiony look.) So in the long run price controls will make things worse.

I don't know how long the long run will take. And I can't model it. Its very nature makes it hard to model. Maybe impossible to model. If an armchair economist like me could fully model a market economy, we wouldn't need a market economy. Just make me central planner.

It seems that the long run is the time it would take to build competitor factories, or the time it takes to design/build-out cheaper manufacturing processes (with a lower MC). If the government freezes prices, then there is no incentive to build these. So real output (or this product) falls from the no-price-control path. I think your model is hiding this because it assumes that the government can do this, but still increase AD and output. So you assume that these guys will not build the factory, but go build something else in it's place. Is there a fallacy of composition there?

It's possible that we need lots of price controls before the fallacy shows up. Or maybe a price control on some less-specific factor of production, like oil, will do it?

Everything you say about the relevance of Austrian uncertainty and the calculation problem is spot on.

But, the question is not whether there might be benefits of price controls vs the status quo (excess inflation). The question is whether there could be benefits, even short term, compared to just setting the real rate at natural rate. I.e. if you force a low real rate and stable goods prices, can you get something better than a non-inflationary real rate with market determined goods prices?

Or to put it even clearer: You are imagining that the Argentinian government might, in some alternate universe, get all prices right. Sure. But all prices *include* the real rate. In *this* universe they most definitely are not getting the real rate right. The whole point of using price controls is to avoid raising interest rates. So besides inevitably failing on the calculation problem, they aren't even trying to get some prices right. They are just distorting some prices to compensate for the fact that they are already distorting other prices.

So the simple critique doesn't need to resort to Austrian arguments, any more than does a proper critique of price controls under the Nixon administration. The problem is just failed monetary policy, i.e. rates are too low.

RPLong: Yep, nowadays most discussions of price controls are partial equilibrium micro discussions. Because governments only put price controls on one or two goods, so partial equilibrium micro analysis makes sense. But back in the olden days, when I were just a lad, many countries actually had economy-wide price (and/or wage) controls on all/most goods. And that's what Argentina is doing now, time-warp style, back to that 70's show. So we need a general equilibrium model with money in order to analyse their effects. We're talking macro. Nobody has talked about this since the 1970's.

marris: "I think your model is hiding this..."

I agree my model is hiding a lot of things, including that. That's part of what this post is about.

K: If the economy is monopolistically competitive, then the natural rate of Y will be lower than optimal. (The natural rate of r may be higher or lower than optimal.) Price controls plus loose money can, in principle, in my simple model, increase Y above the natural rate to the optimal level Y^.

Nick,
If price controls will make things worse in the long run and people have rational expectations, isn't it possible that the imposition of price controls will make things worse in the short run as well? For example, I would imagine that the required return on investment (ex ante returns) might rise substantially due to the fact that investing in businesses that are not allowed to change their prices in the future as conditions change in much riskier than investing in businesses that are allowed to change their prices. And a higher required return coupled with a sharp decline in expected future profit margins could result in plunge in investment and a leftward shift in AD that might overwhelm the (what I think is a very small) rightward shift in the LRAS curve. I suppose you would argue that the central bank would prevent the recession and keep AD on track. Maybe, but not if the central bank doesn’t realize that people are rational and will raise their required returns. And not if the government tells the central bank not to ease policy in the wake of the imposition of price controls. And if people are REALLY rational they'll realize that the central bank is unlikely to offset the short-term impact on investment and cut thier expectations of future income growth leading to a decline ion consumption as well.

I agree that economy-wide price controls require a general-equilibrium analysis in principle, but I don't think that this makes the "micro" perspective useless.

Indeed, _if_ price controls are beneficial in the short run, then this can easily be captured by a micro analysis: price controls may force a firm with monopoly power to set price closer to marginal cost.

On the other hand, this implies that excessively strict price controls may also deprive firms of the returns they need to defray fixed costs, such as investments. Such effects will be especially visible in the longer run, where past, "sunk" investment is not relevant: price controls will induce firms to scale back their investments or exit the relevant market outright.

It is pretty easy to build a model that shows that price controls are a bad thing. Start with the micro model... Any price away from the market price creates shortages, hoarding, black markets and an inefficient allocation of resources.

Hmm, I'm confused. I thought the argument against price controls (and central planning in general) is mostly about how unlikely it is that the price setter will fix P < MC, therefore producing shortages. But you just assumed away that possibility, so that conclusion cannot be reached. Were you trying to find other reasons to declare price controls bad?

There is probably reason for that. In the short term price controls can be a good thing such as in temporary response to disasters. In the long term they are bad but in the long term they are always abandoned because of this. So this may well be a mistake but it won't take long to discover this. Sometimes these programs simply evolve into a means of providing welfare without significant effects on markets.

I'd add that in addition to the austrian critique that the government doesn't literally know everything about every good or service, there is an administrative cost to having a bureaucracy manage prices instead of the businesses themselves. To some extent the growth of government bureaucracy would be offset by a decrease in corporate bureaucracy--corporations no longer need to employ pricers of their own--but I think it is fair to say that there would still be a very large additional bureaucratic cost to trying to maintain an efficient price system through central planning.

I'd add that not all economy-wide price control schemes were failures. During world war 2, the US government seized most US factories and most of the domestic labor force, and in addition regulated the prices of most everything else. The system remained in place until its gradual dismantling in the 1950s. Arguably this all made individuals worse off by any normative measure--subjective utility was probably lower--but it lead to massive growth in GDP and individual incomes, making people better off by many positivist measures.

First, congratulations for not confusing issues with empirical economics. Second, would not micro-economic models be a more appropriate starting point for a theoretical treatment? Perhaps then move to a time inconsistency model.

The really interesting news out Argentina is the expropriation of Repsol's share of YPF SA _after_ the company made a massive oil shale discovery in the Neuquen basin. Apparently the Argentinian economists felt that models readily illustrated the immediate benefits of re-nationalization but that models could not demonstrate the negative impacts of such a move.

It really is about how difficult it is for anyone to solve an optimization problem, including market participants.

You need a magic fairy assumption that the crowd will be wise.

But if you are free to create your own magic fairy, you might as well assume that everyone has adequate information, makes predictions of the future with mean zero error, and behaves optimally, including government.

We just went through a housing bubble in which those making the worst decisions with the worst expectations of future prices were rewarded the most, and this blew up the economy.

With price controls, the devil is in the details. While it's an obviously impossible coordination problem to have total detailed economically efficient central price controls, the problems that arise depend on the government's choice of compromise with this reality. Many different sorts of price control systems have been tried. This article discusses some of the possibilities:

http://www.econlib.org/library/Enc/PriceControls.html

There are certain threads:

When the set price of a good is below cost, there will be shortages, and there will always be some cases of such prices.

Any broad long term set of price controls will involve rationing, for perceived fairness and prevention of diversion.

Inflation due to loose monetary policy can be delayed by price controls, but not prevented, making lifting controls a problem.

Consumers also have roles in production, and measures that reduce their productivity will be counterproductive. They can have an effect like the US income tax as a form of tax collection - massive waste of time and high cost of compliance.

People will find ways of exploiting any perverse incentives created by price controls. Our Medicare system is a rich source of examples of this.

"I can easily build a simple macroeconomic model showing that price controls are a good thing that can make everybody better off."

"I cannot build a simple macroeconomic model showing that price controls are a bad thing. I don't think anyone else can either. Unless they assume the government price controllers are stupid. But that doesn't mean price controls are not a bad thing."

First question, can a government set the price of physical good? Certainly. They can either be the monopoly producer of that good or the monopoly consumer of that good.

Few would argue that the government cannot effectively set the price of air craft carriers or fighter air craft or space shuttles. The sale price of the good the government is buying is negotiated between buyer and seller rather than relying on market pricing.

The problem governments get into is when they try to legislate prices of goods / labor when they cannot purchase the excess or provide additional goods / labor to handle shortages.

Which is why governments should stick to regulating the cost of their money - both pretax and aftertax.

does the price stop also include wages in your simple monopolistically competitive model? I guess no. If it would, price stops combined with an increase in AD could not raise output in equilibrium because a depressed markup can only be achieved if nominal wages adjust upwards.

stw: If we assume monopoly power in the output market only, my simple model would require price controls but not wage controls. If instead we assumed monopoly power in the labour market only, my simple model would require wage controls but not price controls. If both, then both.

I'm sure this could be modelled relatively simply (by someone like Mike Woodford, not me). Start with your standard NK model + price controls producing an efficiency gain. Then add an unobservable random shock to each firm/market each period so that MC follows a random walk. Those markets where the random walk produces a rise in MC will produce shortages, and those where MC falls will be returning to their previous (monopoly DWL) situation. You lose both ways, and both will accumulate over time.

(This is assuming the govt can't observe anything and just keeps the same price controls. If they take shortages as a signal to raise prices you could do all sorts of fancy signalling/screening games.)

"That's the Fallacy of Composition. For example, the supply of labour to any individual firm might be perfectly elastic, even if the aggregate labour supply is perfectly inelastic."

Uh, Nick? One can add perfectly elastic curves and get a perfectly inelastic curve. All it requires is that the curves aren't centered on the same value. This is basic calculus, as a matter of fact - the idea that each curve can be represented as an infinite number of delta functions.

You didn't disprove the idea that the macro sphere can be an aggregate of the micro relations. And references to the fallacy of composition don't do you any good - that's not really a fallacy most of the time. Like with Keynes' nonsensical "paradox of thrift", which stems from a confusion of capital and savings with nominal monetary amounts.

Matt: even if all curves are centered on the same value (whatever that means, and it doesn't matter, because this works even if all curves are identical) each individual curve can be perfectly elastic and the aggregate curve can be perfectly inelastic. And it's got nothing to do with calculus, basic or otherwise. Each individual firm's curve holds the other firms' wages constant. The aggregate curve has all firms changing wages at once. The aggregate labour supply curve is not the (horizontal) summation of the individual firms' labour supply curves.

"I cannot build a simple macroeconomic model showing that price controls are a bad thing."
I'm not sure how to interpret this sentence. A price control equal to the equilibrium price has no effect and one away from it creates a deadweight loss. Furthermore, price controls make prices much stickier, which in pretty much any macro model leads to worse outcomes, and I know you know all this. I've read your articles on macro in a world of monopolistic competition, but the odds of a government actually guessing the price where P=MC is implausible. As much as I like Hayek's work, I don't think you need it to show why price controls can be inefficient.